The U.S. Economy at Risk for Deflation

[dataguru]

When policymakers at the Federal Reserve voted to slash interest rates
at their Oct. 28-29 meeting, it's a good bet the threat of deflation
played a role in the decision. That concern is bound to get more
attention in coming months as inflation begins to fall amid a
progressively weaker economy and the financial crisis. Deflation is an
economic disease caused by a sustained drop in overall demand and
falling prices that forces businesses to cut prices ever deeper. It
was last seen in the U.S. in the 1930s and in Japan in the 1990s, when
the inflation rate fell to zero and then turned negative for several
years.

Deflation is a nasty situation that can give central bankers
palpitations. It's especially onerous for borrowers. Because prices
are falling, people who already owe money have to pay back loans in
dollars that will buy more goods than the dollars they borrowed. For
new loans, it raises the real, or inflation-adjusted, cost of credit,
the opposite of what monetary policy needs to do to combat falling
demand. Plus, in the effort to boost spending, policymakers cannot cut
the target rate below zero. At that point, negative inflation can keep
the real rate high enough to restrict economic growth.

The risk of deflation is small but not at all trivial. The last threat
in the U.S. followed the tech bust and recession in the early 2000s.
Back then, the Fed fought off what it euphemistically called "an
unwelcome substantial fall in inflation" by cutting its target rate to
1% and keeping it there for a year. But the power of those rate cuts
was aided by a strong financial sector. As then-Fed Governor Ben
Bernanke said in a 2002 speech: "A healthy, well-capitalized banking
system and smoothly functioning financial markets are an important
first line of defense against deflationary shocks."

Without that backstop this time, the U.S. faces a new round of
deflationary forces. All of the factors that fueled earlier inflation
worries have sharply reversed course: Consumers are retrenching. Job
and wage growth are weakening at faster rates. The stronger dollar is
pushing down import prices. Oil prices have plunged, and even
excluding oil, commodity prices have collapsed. Cheaper oil will
magnify the coming slide in overall inflation. Yearly consumer
inflation peaked at 5.5% in July but is set to fall to close to zero
by early next year. Still, prices outside energy and food will
determine whether broader inflation may be falling too rapidly.

The danger there, also unlike in the early 2000s, is that U.S. demand
is falling outright. It fell sharply in the third quarter, and
consumer confidence hit an all-time low to begin the fourth quarter.
Asset-price deflation is especially corrosive. Since their peaks, the
Wilshire 5000 stock index has fallen 40% despite the Oct. 28 surge,
and the Standard & Poor's Case-Shiller Home Price index is down 20%.

www.businessweek.com/magazine/content/08_45/b4107008158343.htm